Douglas Porter

October 20, 2023

Can anything hold back the relentless and remorseless tide of rising bond yields? After a short-lived reprieve last week, the 10-year Treasury yield charged back up more than 40 bps to briefly grip the 5% handle for the first time since 2007 on Thursday. A series of generally stronger-than-expected U.S. data, as well as a high-side surprise on China’s Q3 GDP, reinforced the sense that the economy is withstanding the many headwinds. Meantime, it was another week of a speaker-less House in Washington, driving home the point that fiscal finances will continue to run amok. And while Chair Powell’s speech added to the view that the Fed will stay on pause in November, he also left the door open for further moves if needed, thus doing little to stem the selling tide.

On the economic front, the main trigger this week was September’s surprisingly perky U.S. retail sales gain of 0.7%. While we can quibble about the details, sales have now risen for six consecutive months by an average of 0.6% per month. We’ve made the point before, but that pattern of consumer spending is not even in the same zip code as a recession. In a similar vein, initial jobless claims drooped below the 200,000 level in the latest week (also the jobs survey week), the lowest since January, and pretty much the opposite of what a serious slowdown would look like. No doubt, housing is struggling, as are large parts of manufacturing. Yet, we have ramped our call on next Thursday’s Q3 GDP report to 5%—there’s that 5% figure again.

It was a broadly similar story in the world’s second-largest economy. China topped expectations with a 1.3% rise in Q3 real GDP (a bit above a 5% annual rate), or 4.9% above a year ago. Tfhe main point is that the official aim of 5% growth for the full year is now well within reach, even in the face of the deepening property gloom. Chiming in, both industrial production (4.5%) and retail sales (5.5%) landed above consensus, and both circled that 5% figure. We would highlight another, less publicized, data point from this week that frames the pressure on U.S. bond yields. China reduced its holdings of Treasuries by another $16 billion in August, bringing the cumulative drop to $133 billion over the past 12 months. On the other side, foreign direct investment into China has dropped by more than 8% this year: de-risking in action.

The powerful rise in long-term interest rates is weighing increasingly on other markets. After peaking in late July, the S&P 500 is now down by more than 7%. Much of the focus this week was on the mixed bag of Q3 earnings reports, but the back-up in bond yields is noisily pounding away in the background. For the most part, the sustained rise has been driven by real yields, with the 10-year real rate jumping by nearly 100 bps in a mere three months (to almost 2.5%). However, in the past two weeks, that selling has been compounded by an uptick in inflation expectations, spiked by $90 WTI amid the Mid-East conflict.

The rise in real yields can be attributed to the dawning realization that central banks truly are girding for high-for-longer. But we would again highlight the added concern over the injured state of government finances. Years of low, or negative, real interest rates had lulled many policymakers into a false sense of security on budget deficit dynamics, which culminated in the frenzy of stimulus during and even after the pandemic. It would not be overly dramatic to suggest that the day of reckoning is now at hand. The question is whether policymakers are fully aware of how the rules of the fiscal game have abruptly changed as a result of the reset in real interest rates.

Canada is certainly not immune to this new reality. While bond yields remain better contained—the 10-year yield is “only” 4.1%, and 30s remain curiously subdued at less than 4%—they’re a long way from the years of around 2% prior to and during the pandemic. Against this fraught backdrop, the Bank of Canada is widely expected to hold its key rate steady at next week’s decision. That was less than an obvious choice prior to this week. But a combination of a very weak Q3 Business Outlook Survey and a welcome drop in CPI inflation back below 4% made the decision much more straightforward. We continue to believe 5% rates are plenty restrictive, and that, yes, the global run-up in bond yields will do a lot of the tightening work for central banks.

Rhyme Time from the History Books: This week marked the 36th anniversary of the single worst day in U.S. stock market history—October 19, 1987, or Black Monday. Not to trigger painful memories, but the Dow Jones fell by a whopping 22.6% in that session, while the S&P 500 was let off for good behaviour with a 20.5% haircut. (The TSX fell “only” 11.1% that fateful day, which was actually topped on March 12, 2020 by a 12.3% plunge.) The precise causes of the devastating drop have long been debated, with many pointing the finger squarely at program trading as a culprit, as well as a fast-fading U.S. dollar amid policy frictions between the U.S. and Germany.

But the elephant in the markets that year was a dramatic and sustained run-up in bond yields, set against the backdrop of a tightening Fed, sticky 4% inflation, and squabbles in Washington over a bloated budget deficit. After starting the year at just above 7%, the 10-year Treasury yield pierced the 10% barrier in the days just prior to the crash—the last time that term would ever see double digits. With the Fed quickly cutting rates, yields were back below 9% within days of the crash.

What really stood out during the first nine months of 1987 was the wide divergence between stocks and bonds, with the former blithely rallying strongly (the S&P 500 was up 33%) and the latter swan-diving. Something had to give, with such a wide valuation gap developing between the two. Not to add to the recent sour mood, but doesn’t that sound at least vaguely familiar? The good news is that even with the October 1987 wipeout and all the wild gyrations, the major U.S. averages still ended that year with 2% gains—the traumatic crash had neatly, perhaps efficiently, skimmed off the froth. It had simply taken a market earthquake to properly reset valuations.

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.